In your experience, what’s the biggest misconception people have with credit cards? - Industry Roundup #15

Issue #15 centers on common misconceptions that people have about credit cards. Jason Steele asks our group of credit card experts what is the most common misconception that the general public has when it comes to credit cards. A great group of responses for this issue of the Credit Card Reviews Expert Roundup:

In your experience, what’s the biggest misconception people have with credit cards?

There seem to be so many misconceptions about credit cards, it’s hard to choose one. There used to be times when people thought their credit score would suffer if they checked it on their own. Fortunately, this ridiculous but amazingly stubborn myth has (mostly) been put to bed.
Many others exist, though. One of the most persistent misconceptions, in my opinion, is this:

I’d better close down a credit card if I don’t use it.

It can be true in some instances. For example, you might not want to keep an annual-fee card if the benefits of the card don’t justify the fee. Otherwise, however, you’d be better off keeping the card even if you don’t use it. The reason is a utilization ratio, a crucial component of the FICO credit scoring formula. Utilization ratio is the ratio of your debt to your credit. The lower this ratio – the better it is for your credit score. Many financial experts recommend keeping it at least under 30%, while some believe you should aim at under 10%.

Here is an example. Let’s say you have two credit cards with a $3,000 credit line each. If you make a big-ticket purchase, like a TV for $1,500, that you can’t pay off right away (or won’t because you might still carry a 0% introductory APR, for example), your utilization ratio will be 25% presuming you pay all your other expenses in full. However, if you close one of the cards your utilization ratio will be 50%, which will make your utilization ratio go up and might make your FICO score go down.

This is why it’s important not to close your no-annual-fee card in haste. You don’t have to use your available credit. You can put your unneeded credit card in a sock if you wish, and it will still work for you in maintaining your overall healthy credit history.

The most harmful and widespread misconception about credit cards that I have seen is the belief that you have to carry a balance in order to improve your credit score. I'm not sure where this idea came from, since carrying a balance has no positive effect on your credit score--and in fact, carrying a high balance from month to month can potentially ding your credit score since your debt-to-credit limit ratio constitutes about 30% of your credit score. Borrowers who carry a low balance that they could easily pay off are simply sending unnecessary interest to their credit card issuer, while those who carry large balances and believe they are making a good credit decision are both overpaying in interest, and potentially shooting themselves in the foot in regards to improving their credit score.

Paying off your credit card every single month is the best way to maintain (and possibly improve) your credit score. That's because the two most important aspects of your credit score are utilization and paying on time. As long as you are using your credit and paying your bills on time, your credit score will reflect that responsible behavior. As an added bonus, doing this means you are also avoiding paying interest on your purchases and taking advantage of your credit card rewards for free.

There's a myth floating around that you need to carry a balance on your credit cards to build and maintain good credit. This is not correct, and carrying a balance can cost you in interest. The amounts owed across all credit accounts count for 30 percent of your FICO score, and you actually get penalized if you're utilizing a high percentage of your available credit.

This is why experts recommend keeping your overall credit utilization below 30 percent and ideally below 10 percent. So, if you had $10,000 in total available credit, and your combined credit card balances totaled $5,000, you'd be utilizing 50 of your available credit and your credit score would get dinged for using so much credit. With $10,000 in available credit, you'd want to charge no more than $1,000 so you'd be at or below 10 percent utilization.

Here's another wrinkle consumers need to know about: Even if you pay off your balance in full every single month, your credit utilization may still be higher than zero. That's because the credit bureaus don't wait until your payment due date to calculate your credit utilization. You can make several micro-payments on your credit cards over the course of the month to keep your credit utilization low. This also prevents bill shock at the end of the month.

What if you can't pay off your balance in full? Rewards credit cards tend to carry a higher interest rate than non-rewards cards, so if you do need to carry a balance, look for a no-rewards, lower-interest card and be sure you're making at least your minimum payments each month.

I routinely hear readers and followers who believe utilizing credit cards is bad for your credit score and credit profile. They ask me how much my credit score has dropped since earning points and miles or worry they won’t be able to qualify for a mortgage with multiple credit cards on their credit report. The truth of course is that credit cards, used responsibly, can dramatically increase your score, especially for someone young with no credit history.

I believe this stems from the immediate and slight drop in your credit score after a hard inquiry is made to be approved for a credit card. Within a couple months your score has recovered and typically surpassed where you were before receiving a new card. Credit cards with no balances decrease your credit utilization ratio, add to your credit mix, allow you to make on-time payments, and over time obviously add to your length of credit history. These are all positive attributes according to what we know about the FICO score and credit card holder’s scores increase. This all assumes responsible use of credit, never forget that.

When talking with people about credit cards at the bar or other social situations (because that's what normal people talk about... right?), people often overestimate the cost of credit cards and underestimate the value of rewards. But these misconceptions about the potential of credit cards likely stem from a negative past experience or a negative experience from a friend or family member. When you don't pay off your bill in full, it is easy to see credit card balances balloon out of control and turn into a big pile of debt that is hard to dig out of. But for responsible credit card users, interest and fees are hardly a consideration.

When you pay off your card in full every month, you never have to pay interest. And if you use your card responsibly, you won't ever pay any fees outside of an occasional annual fee. I have never paid a penny of credit card interest and I've been using credit cards for about 15 years. In the last ten, where I've been more focused on credit card rewards, those cards have led to free and discounted trips around the world. And because I pay my cards in full every month and only pick cards that meet my needs, I end up making money from my cards, not losing it.

Greg Johnson - Personal finance and frugal travel expert who leveraged his online business to quit his 9-5 job

The biggest misconception I see is that people believe credit cards are an automatic ticket to financial disaster. Yes, for some people, a credit card can be a dangerous tool. They use them to overspend, rack up debt, and get themselves into serious financial trouble. Still, the card itself is just a tool. When used properly, it can actually be a huge benefit to users. Credit cards even offer significantly more protections in the case of fraud than a debit card alone.

Another major misconception is that earning rewards is not worth it. I hear this one all the time, especially when it comes to cards that charge an annual fee. Although some cards with fees may not provide great value, many cards offer gigantic signup bonuses that more than cover the cost of the fee. Others offer on-going benefits and credits that might make the cost of the fee worth it. Even better, several of the best rewards cards waive their annual fee for the first year, allowing users to try the card for free! A little research and simple math goes a long way in determining if a rewards card will be worth it.

In my opinion, it makes zero sense to use a card that doesn’t offer some great rewards. There are dozens of cards to choose from, so why use a card that offers very little in return? With that said, it’s imperative to pay off the balance in full every month. This helps users avoid expensive interest payments, keeps them mindful of their spending, and ensures that consumers aren’t spending more for rewards than they’re getting in return.

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